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Fed & ECB: Towards a reduction in monetary accommodation

The improvement of global economic conditions will allow the Fed and the ECB to reduce the degree of monetary accommodation, each with its own scale: continuation of the fed funds rate hike cycle for the Fed and reduction of asset purchases for the ECB. True, underlying inflation measures remain weak on both sides of the Atlantic but the evolution – even timid – of wages and the dissipation of temporary factors should reassure the two central banks : inflation will return to their targets. Other factors will prompt the Fed and the ECB to remove monetary policy accommodation: the sharp easing of financial conditions in the US for the Fed and the technical constraints attached to the QE implementation (in its current form) for the ECB. The ECB and the Fed will be very cautious in their communication and will telegraph their actions beforehand.

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October 2017

Octobre 2017

Global growth surges upward

In most countries, domestic demand is stronger than expected, including business investment, which has been particularly weak in recent years.

The stabilization of the Chinese economy has allowed global trade to recover from the end of last year, and to grow faster than global GDP growth (thanks in particular to growth in Asia). As a consequence, the trade multipliers maintain the recovery: the resynchronization of the world cycle is an essential element of the «positive surprise» on global activity in the first half.

Recoveries supported simultaneously by several engines are by nature more robust than one engine - recoveries. The global economy is currently enjoying a virtuous mini circle that can continue for several quarters in a row. In this context, inflation risks are rising in both the United States and Europe, especially as current inflation levels are particularly low.

Monetary and financial conditions remain extraordinarily accommodative on both sides of the Atlantic.

The real interest rates of the Fed and the ECB are still in negative territory. This contrasts sharply with past cycles, where inflation accelerated more sharply when growth was robust, leading central banks to more rapidly normalize monetary policy.

Monetary and financial conditions continued to ease slightly in the United States with the depreciation of the dollar, falling bond yields rates and rising stocks, despite the rise in the fed funds rate. This easing in turn supports US economic activity1. Growth is likely to remain above the average potential growth in H2. There is no risk of recession in these conditions.

In the euro zone, the situation is different but the conclusion is the same: monetaryconditions are excessively accommodative. There is a cycle lag between the euro area and the United States. While the recovery began in the spring of 2009 in the United States, the euro area is the only region to have experienced a double recession. The recovery started in 2013. Most of the economies in the area are still far from full employment (Germany is an exception). It will take additional years with growth above potential to completely purge excess capacity in the periphery economies, hardest hit by the consequences of the sovereign debt crisis. The euro area is mid-cycle while the United States is nearing an end of cycle.

The low level of inflation is surprising at this stage in most countries

In the United States, underlying inflation has slowed considerably since the beginning of the year, while the cycle has continued steadily for more than 8 years, the economy continued to create jobs at a sustained pace , with unemployment at the lowest level since 2006.

There is still some slackness in the labour market (low participation rate, constrained part-time or average duration of unemployment above historical standards), but the situation is improving continuously and it is reasonable to anticipate that wages will accelerate by 2018, which is also indicated by business surveys. Risks are asymmetric in this area.

Low inflation is also attributable to one-off factors that are not expected to last, or probably not with the same intensity. The decline in telecommunications prices largely explains the slowdown in underlying inflation in March-April in the United States (about 20 bps). Since then, these prices have stopped falling (a positive base effect will mechanically result in next spring’s underlying US inflation).

Wage pressures are already emerging in the euro area. If job creation continues at the same pace, cyclical underlying inflation will increase more clearly.

The rise in the euro will come to contain the upward pressure on prices (unlike the United States where the fall of the dollar plays positively on inflation). That said, the pass through will probably be limited. This is generally the case in demand recoveries because domestic cyclical factors outweigh temporarily imported disinflation (the transmission to firms’ margins of a shock on the exchange rate depends on the position of the economy in the cycle).

The favorable dynamics of credit to the private sector in all the euro zone countries illustrates the strength of domestic demand (the total volume of bank credit to corporates is up 2.5% over one year, the highest since mid-2009).

The ECB downgraded its underlying inflation expectations in 2019 (1.5%) due to the rise in the euro, but may have overestimated the negative impact on prices of the recent appreciation of the euro.

Why the Fed should continue its fed funds tightening cycle

The Fed’s dual mandate is almost fulfilled: the unemployment rate is already below the longer-run level estimated by FOMC members and inflation is not that far below the Fed’s 2% inflation target. Besides, the other measures of slack in the labour market are improving as well.

The issue of the risk of financial stability is increasingly fuelling the debatesof the FED. Minutes of the last FOMC pointed out that an environment of low interest rates and a relatively flat yield curve, if it persisted, had the potential to boost incentives to take on leverage and risk.

The corporate leverage has hit historically high levels, in particular for large companies able to borrow on financial markets. These companies have beenable to take advantage of the low interest rates and of the ultra-accommodative implemented by the major central banks. The proceeds of this borrowing have mostly been used to finance M&A operations and share buybacks. Companies had little incentive to invest in an environment of weak growth. Recently, the M&A activity and share buybacks have slowed in the United States. As a consequence of this higher caution, there has been a stabilization of corporate leverage.

The risks associated with consumer credit has strongly risen. They now account for $3640 bn, ie a level largely above the peak hit in 2008.

Valuation pressures appeared to have risen for some types of assets. FOMC members warned that the recent increase in equity prices might in part reflect investors’ anticipation of a boost to earnings from cut in corporate taxes or more expansionary fiscal policy, which might not materialize. Some participants also expressed concern about the low level of implied volatility in equity markets.

The Fed admitted also commercial real estate is a big concern.

Financial conditions eased since the beginning of the fed funds tightening cycle (December 2015). During previous fed funds tightening cycles, either financial conditions remained stable or they tightened. Several indicators like the Saint Louis financial stress index at close to an all-time low. William Dudley, the New York Fed’s president said on September 7: “if financial conditions ease even as we are removing monetary policy accommodation, this may have implications for further policy adjustments. All else equal, an easing of financial conditions may warrant a somewhat steeper policy rate path.”

Why the ECB should continue the normalization of its monetary policy

The improvement of the macro backdrop (see above) and the abatement of deflationary risks allow the ECB to reduce its emergency measures. The economic situation is globally close to where it was in the US in mid-2013 when Ben Bernanke evoked the idea of a tapering of the Fed’s QE. But there are also technical grounds for which the ECB should reduce its asset purchases in 2018.

The extension of the ECB’s QE is limited because of technical constraints. Under the QE program initiated in March 2015, the Eurosystem (the ECB and all national central banks) have already purchased nearly €2060bn in assets (August data), including over €1,700bn under the PSPP. The ECB has set purchase limits for each QE sub-program and these limits will be reached relatively soon. As for the PSPP, which is the ECB’s largest QE sub-program, the holdings limits are: 1) the Eurosystem may not hold over 33% of a given government’s bonds (whether purchased under the PSPP or not), 2) the Eurosystem may not hold over 50% of a given supranational institution’s bonds. The continuation of the PSPP is inseparable from the capital key rule. Up to now, the PSPP has been implemented in accordance with the capital key rule: Eurosystem sovereign bond purchases are made in proportion to each country’s share of the ECB’s capital (26.3% for German, 20.7% for France, 18% for Italy, 12.9% for Spain, etc.). Much ink has been spilled on the possibility of the capital key rule being removed, but in reality the rule is apparently a condition for the extension of the program. On 31 December 2016, Benoit Coeuré, a member of the ECB’s Executive Board, said that the Governing Council was “very reluctant” about changing these rules, mainly for two reasons: 1) the limits on issues and issuers “serve as a safeguard against monetary financing of governments”, and 2) “they ensure adequate price formation on markets.” Meanwhile, the Bundesbank is very much opposed to the idea of abandoning the capital key rule, feeling that it would create a moral hazard and raise the issue of inappropriate funding of high-deficit governments. Thus far, the Eurosystem has only marginally deviated from the capital key rule, although these deviations have tended to widen over as the months go by, with purchases below the theoretical weight for Portugal, Ireland, Finland and Germany, but above for France, Italy, Belgium and Austria. Contrary to what can be read in the press, German, Portuguese and Irish sovereigns are not the only bonds whose holdings limits are fast approaching. In fact, Spanish, Finnish and Dutch bonds are also in the same boat.

Besides, the end of the ECB’s net asset purchases does not mean it willwithdraw from the bond market. The ECB has announced that it will reinvest bonds reaching maturity long after the QE program has ended: while the Fed made its last QE3-related purchases in Q4 2014, it will not begin the non-reinvestment of maturing bonds until Q4 2017 (i.e. three years later).

The continuation of a QE policy for too long would raise further the banks’ excess reserves, already at €1800 bn. This would raise concerns for the banks as they would have to pay a negative interest rate on even bigger amounts and this may encourage price bubbles to form.

Conclusion

Financial markets remain very cautious on the ability of the Fed to hike its fed funds in the coming quarters: indeed, they only expect three rate hikes until the end of 2019 while FOMC members expect six hikes. We expect the Fed will hike the fed funds in December and at least twice next year.

The ECB will announce at the 26 October Governing Council a substantial reduction of the pace of its asset purchases in 2018. The QE extension may be 6 months at a €30 bn monthly pace. A longer extension (9 months) would send the signal of an even later ECB rate normalization.

The global economy is currently benefiting froma virtuous mini circle.

World inflation prospects remain moderate in theUnited States and the euro area.

In the United States: the risks associated with financial stability outweigh the problem of low inflation.”

The ECB cannot extend “too much «the PSPP if it wants to remain roughly in linewith the capital key rule.”

1. The negative impact of hurricanes will be short-lived; in the rich countries, natural disasters always generate, in the second phase, reconstruction spending which compensates for, or even prevails over, the initial negative impact. Central banks should therefore not take into account, as much as possible, the short-term impact.